2.1– Decoding the basic jargons

In the previous chapter, we understood the basic call option structure. The idea of the previous chapter was to capture a few essential ‘Call Option’ concepts such as –

It makes sense to be a buyer of a call option when you expect the underlying price to increase

If the underlying price remains flat or goes down then the buyer of the call option loses money

The money the buyer of the call option would lose is equivalent to the premium (agreement fees) the buyer pays to the seller/writer of the call option.

In the next chapter i.e. Call Option (Part 2), we will attempt to understand the call option in a bit more detail. However before we proceed further let us decode a few basic option jargons. Discussing these jargons at this stage will not only strengthen our learning, but will also make the forthcoming discussion on the options easier to comprehend.

Here are a few jargons that we will look into –

Strike Price

Underlying Price

Exercising of an option contract

Option Expiry

Option Premium

Option Settlement

Do remember, since we have only looked at the basic structure of a call option, I would encourage you to understand these jargons only with respect to the call option.

Strike Price

Consider the strike price as the anchor price at which the two parties (buyer and seller) agree to enter into an options agreement. For instance, in the previous chapter’s ‘Ajay – Venu’ example the anchor price was Rs.500,000/-, which is also the ‘Strike Price’ for their deal. We also looked into a stock example where the anchor price was Rs.75/-, which is also the strike price. For all ‘Call’ options the strike price represents the price at which the stock can be bought on the expiry day.

For example, if the buyer is willing to buy ITC Limited’s Call Option of Rs.350 (350 being the strike price) then it indicates that the buyer is willing to pay a premium today to buy the rights of ‘buying ITC at Rs.350 on expiry’. Needless to say he will buy ITC at Rs.350, only if ITC is trading above Rs.350.

In fact here is a snap shot from NSE’s website where I have captured different strike prices of ITC and the associated premium.

The table that you see above is called an ‘Option Chain’, which basically lists all the different strike prices available for a contract along with the premium for the same. Besides this information, the option chain has a lot more trading information such as Open Interest, volume, bid-ask quantity etc. I would suggest you ignore all of it for now and concentrate only on the highlighted information –

The highlight in maroon shows the price of the underlying in the spot. As we can see at the time of this snapshot ITC was trading at Rs.336.9 per share

The highlight in blue shows all the different strike prices that are available. As we can see starting from Rs.260 (with Rs.10 intervals) we have strike prices all the way up to Rs.480

Do remember, each strike price is independent of the other. One can enter into an options agreement , at a specific strike price by paying the required premium

For example one can enter into a 340 call option by paying a premium of Rs.4.75/- (highlighted in red)

This entitles the buyer to buy ITC shares at the end of expiry at Rs.340. Of course, you now know under which circumstance it would make sense to buy ITC at 340 at the end of expiry

Underlying Price

As we know, a derivative contract derives its value from an underlying asset. The underlying price is the price at which the underlying asset trades in the spot market. For example in the ITC example that we just discussed, ITC was trading at Rs.336.90/- in the spot market. This is the underlying price. For a call option, the underlying price has to increase for the buyer of the call option to benefit.

Exercising of an option contract

Exercising of an option contract is the act of claiming your right to buy the options contract at the end of the expiry. If you ever hear the line “exercise the option contract” in the context of a call option, it simply means that one is claiming the right to buy the stock at the agreed strike price. Clearly he or she would do it only if the stock is trading above the strike. Here is an important point to note – you can exercise the option only on the day of the expiry and not anytime before the expiry.

Hence, assume with 15 days to expiry one buys ITC 340 Call option when ITC is trading at 330 in the spot market. Further assume, after he buys the 340 call option, the stock price increases to 360 the very next day. Under such a scenario, the option buyer cannot ask for a settlement (he cannot exercise) against the call option he holds. Settlement will happen only on the day of the expiry, based on the price the asset is trading in the spot market on the expiry day.

Option Expiry

Similar to a futures contract, options contract also has expiry. In fact both equity futures and option contracts expire on the last Thursday of every month. Just like futures contracts, option contracts also have the concept of current month, mid month, and far month. Have a look at the snapshot below –

This is the snapshot of the call option to buy Ashok Leyland Ltd at the strike price of Rs.70 at Rs.3.10/-. As you can see there are 3 expiry options – 26th March 2015 (current month), 30th April 2015 (mid month), and 28th May 2015 (far month). Of course the premium of the options changes as and when the expiry changes. We will talk more about it at an appropriate time. But at this stage, I would want you to remember just two things with respect to expiry – like futures there are 3 expiry options and the premium is not the same across different expiries.

Option Premium

Since we have discussed premium on a couple instances previously, I guess you would now be clear about a few things with respect to the ‘Option Premium’. Premium is the money required to be paid by the option buyer to the option seller/writer. Against the payment of premium, the option buyer buys the right to exercise his desire to buy (or sell in case of put options) the asset at the strike price upon expiry.

If you have got this part clear till now, I guess we are on the right track. We will now proceed to understand a new perspective on ‘Premiums’. Also, at this stage I guess it is important to let you know that the whole of option theory hinges upon ‘Option Premium’. Option premiums play an extremely crucial role when it comes to trading options. Eventually as we progress through this module you will see that the discussions will be centered heavily on the option premium.

Let us revisit the ‘Ajay-Venu’ example, that we took up in the previous chapter. Consider the circumstances under which Venu accepted the premium of Rs.100,000/- from Ajay –

News flow – The news on the highway project was only speculative and no one knew for sure if the project would indeed come up

Think about it, we discussed 3 possible scenarios in the previous chapter out of which 2 were favorable to Venu. So besides the natural statistical edge that Venu has, the fact that the highway news is speculative only increases his chance of benefiting from the agreement

Time – There was 6 months time to get clarity on whether the project would fructify or not.

This point actually favors Ajay. Since there is more time to expiry the possibility of the event working in Ajay’s favor also increases. For example consider this – if you were to run 10kms, in which time duration are you more likely to achieve it – within 20 mins or within 70 mins? Obviously higher the time duration higher is the probability to achieve it.

Now let us consider both these points in isolation and figure out the impact it would have on the option premium.

News – When the deal was done between Ajay and Venu, the news was purely speculative, hence Venu was happy to accept Rs.100,000/- as premium. However for a minute assume the news was not speculative and there was some sort of bias. Maybe there was a local politician who hinted in the recent press conference that they may consider a highway in that area. With this information, the news is no longer a rumor. Suddenly there is a possibility that the highway may indeed come up, albeit there is still an element of speculation.

With this in perspective think about this – do you think Venu will accept Rs.100,000/- as premium? Maybe not, he knows there is a good chance for the highway to come up and therefore the land prices would increase. However because there is still an element of chance he may be willing to take the risk, provided the premium will be more attractive. Maybe he would consider the agreement attractive if the premium was Rs.175,000/- instead of Rs.100,000/-.

Now let us put this in stock market perspective. Assume Infosys is trading at Rs.2200/- today. The 2300 Call option with a 1 month expiry is at Rs.20/-. Put yourself in Venu’s shoes (option writer) – would you enter into an agreement by accepting Rs.20/- per share as premium?

If you enter into this options agreement as a writer/seller, then you are giving the right (to the buyer) of buying Infosys option at Rs. 2300 one month down the lane from now.

Assume for the next 1 month there is no foreseeable corporate action which will trigger the share price of Infosys to go higher. Considering this, maybe you may accept the premium of Rs.20/-.

However what if there is a corporate event (like quarterly results) that tends to increase the stock price? Will the option seller still go ahead and accept Rs.20/- as the premium for the agreement? Clearly, it may not be worth to take the risk at Rs.20/-.

Having said this, what if despite the scheduled corporate event, someone is willing to offer Rs.75/- as premium instead of Rs.20/-? I suppose at Rs.75/-, it may be worth taking the risk.

Let us keep this discussion at the back of our mind; we will now take up the 2nd point i.e. ‘time’

When there was 6 months time, clearly Ajay knew that there was ample time for the dust to settle and the truth to emerge with respect to the highway project. However instead of 6 months, what if there was only 10 days time? Since the time has shrunk there is simply not enough time for the event to unfold. Under such a circumstance (with time not being on Ajay’s side), do you think Ajay will be happy to pay Rs.100,000/- premium to Venu?. I don’t think so, as there is no incentive for Ajay to pay that kind of premium to Venu. Maybe he would offer a lesser premium, say Rs.20,000/- instead.

Anyway, the point that I want to make here keeping both news and time in perspective is this – premium is never a fixed rate. It is sensitive to several factors. Some factors tend to increase the premium and some tend to decrease it, and in real markets, all these factors act simultaneously affecting the premium. To be precise there are 5 factors (similar to news and time) that tends to affect the premium. These are called the ‘Option Greeks’. We are too early to understand Greeks, but will understand the Greeks at a much later stage in this module.

For now, I want you to remember and appreciate the following points with respect to option premium –

The concept of premium is pivotal to the Option Theory

Premium is never a fixed rate, it is a function of many (influencing) factors

In real markets premiums vary almost on a minute by minute basis

If you have gathered and understood these points so far, I can assure that you are on the right path.

Options Settlement

Consider this Call option agreement –

As highlighted in green, this is a Call Option to buy JP Associates at Rs.25/-. The expiry is 26th March 2015. The premium is Rs.1.35/- (highlighted in red), and the market lot is 8000 shares.

Assume there are 2 traders – ‘Trader A’ and ‘Trader B’. Trader A wants to buy this agreement (option buyer) and Trader B wants to sell (write) this agreement. Considering the contract is for 8000 shares, here is how the cash flow would look like –

Since the premium is Rs.1.35/- per share, Trader A is required to pay the total of

= 8000 * 1.35

= Rs.10,800/- as premium amount to Trader B.

Now because Trader B has received this Premium form Trader A, he is obligated to sell Trader A 8000 shares of JP Associates on 26th March 2015, if Trader A decides to exercise his agreement. However, this does not mean that Trader B should have 8000 shares with him on 26th March. Options are cash settled in India, this means on 26th March, in the event Trader A decides to exercise his right, Trader B is obligated to pay just the cash differential to Trader A.

To help you understand this better, consider on 26th March JP Associates is trading at Rs.32/-. This means the option buyer (Trader A) will exercise his right to buy 8000 shares of JP Associates at 25/-. In other words, he is getting to buy JP Associates at 25/- when the same is trading at Rs.32/- in the open market.

Normally, this is how the cash flow should look like –

On 26th Trader A exercises his right to buy 8000 shares from Trader B

The price at which the transaction will take place is pre decided at Rs.25 (strike price)

Trader A pays Rs.200,000/- (8000 * 25) to Trader B

Against this payment Trader B releases 8000 shares at Rs.25 to Trader A

Trader A almost immediately sells these shares in the open market at Rs.32 per share and receives Rs.256,000/-

Trader A makes a profit of Rs.56,000/- (256000 – 200000) on this transaction

Another way to look at it is that the option buyer is making a profit of Rs.7/- per shares (32-25) per share. Because the option is cash settled, instead of giving the option buyer 8000 shares, the option seller directly gives him the cash equivalent of the profit he would make. Which means Trader A would receive

= 7*8000

= Rs.56,000/- from Trader B.

Of course, the option buyer had initially spent Rs.10,800/- towards purchasing this right, hence his real profits would be –

= 56,000 – 10,800

= Rs.45,200/-

In fact if you look at in a percentage return terms, this turns out to be a whopping return of 419% (without annualizing).

The fact that one can make such large asymmetric return is what makes options an attractive instrument to trade. This is one of the reasons why Options are massively popular with traders.

Key takeaways from this chapter

It makes sense to buy a call option only when one anticipates an increase in the price of an asset

The strike price is the anchor price at which both the option buyer and option writer enter into an agreement

The underlying price is simply the spot price of the asset

Exercising of an option contract is the act of claiming your right to buy the options contract at the end of the expiry

Similar to futures contract, options contract also have an expiry. Option contracts expire on the last Thursday of every month

Option contracts have different expiries – the current month, mid month, and far month contracts

Premiums are not fixed, in fact they vary based on several factors that act upon it

Hi Karthik, thank you for the very good explanations!
Below is my understanding of the options. Please correct if I am wrong.

In options market, nobody is a permanent seller or buyer for the option unless they hold the option till expiry.
A new contract gets created when buyer and seller agree on a strike price & premium.
The current buyer & seller both can get out of the contract by selling the option to another buyer (by receiving premium) OR buying option from another seller (by paying premium) respectively.

Both the buyer and seller can square-off their position before expiry, by selling option or buying option respectively.
Their profit or loss will depend upon the premium at which they bought and sold their option.

If they hold onto the option till expiry, for call option, if the spot price is more than strike price, exchange will exercise the option and buyer will receive the difference between spot & strike price. The buyer will be profitable only if this difference is more than the premium paid. If the option gets exercised, the buyer will have to pay higher STT.

On expiry, for call option, if the spot price is less than strike price, the option will be considered worthless expired.
The premium paid will be buyer’s loss and seller’s gain.

Example:
Suppose there is only one option seller S1 and two buyers B1 & B2.
First S1 will tries to sell one call option and B1 agrees on premium and strike price. B1 pays the premium to S1 and one new contract gets created. Now both S1 & B1 wait for the spot price to move in their preferred direction and premium will change accordingly.
Now suppose premium increased and B1 wants to square-off his position by selling this option. A new buyer B2 who wants to enter the contract or Seller S1 who wants to get out of the contract can buy from B1 by paying current premium. If S1 agrees on the premium asked by B1, this contract will get closed. If B2 agrees for premium asked by B1, the contract will just change hands from B1 to B2. B2 will pay the premium to B1. So now B1 is out of the market and S1 & B2 are waiting for spot price/premium to change.
If B2 wants to hold this option till expiry, and there are no other buyers in the market for this option, S1 will be forced to hold this option till expiry. On expiry, whether this option will exercise or expire worthless, depends upon spot price on expiry.
If the spot price is more than strike price, option will be exercised and if spot price is less than strike price, it will expire worthless.

In real market, there will be thousands of traders who will create new contracts between each other and depending upon their current profit/loss will either square-off or hold the option till expiry. In general, if the demand for the option is more, new contracts will get created increasing OI and if supply is more, some of the contracts will get closed thereby decreasing OI.

One correction:
If B2 wants to hold this option till expiry, and if there are no other SELLERs in the market for this option, S1 will be forced to hold this option till expiry, since he cannot buy and square-off his position. On expiry, whether this option will get exercised or expire worthless, depends upon spot price on expiry.

I’m happy – looks like you got all the points correctly, including the one on STT, which many people miss 🙂

Only one correction – initially S1 and B1 created the contract. When B1 decides to exit the position, the money will get paid to B1 from B2 based on the prevailing premium in the markets. It is important to note here that B1 now transitions to a seller and maybe you can call him S2. There is no direct exchange of money between S1 and B2.

Thanks for the prompt reply Karthik!
I have read through all the comments here and understood most of the answers.
I think, you should create a chapter out of all these Q&A, since some of the questions are repetitive.
Most of the questions are around square-off before expiry, and what happens on expiry.
It will be very much helpful for new readers of Varsity.
If you need help, please let me know, I will be very happy to draft Q&A for you.

I tried buying few 1 8900 NIFTY call option contracts just to clear a few things in my head because I was unsure how to square-off a contract that I have bought. For squaring-off I clicked the ‘Square-off’ button on pi.

1. If instead of clicking the Square-Off button I would have sold 1 lot (25 units) of the same using the ‘SELL’ button (F2 key) , would that have also meant that I would have ‘Squared-Off’ my existing position or would that have meant that I would have continued to have 1 contract of 8900 Call Buy option and I would have sold a different 8900 call option? (I hope I make sense). I must tell you that I am very scared of selling options due to the infinite risk associated.

2. To write options, do we need to click on the ‘SELL’ button and then proceed?

3. How do we exercise an option on the last day? Does the exchange automatically do it for us or do we ‘Square-off’ or Sell?

On a side note: I was trying to do some intraday premium play on the budget day and once a few days before that. Each time I took a position the market moved in the opposite direction and I lost some money. Apparently it is not as easy to make money in options as a friend told me it would be. It is just amazing how can I keep on taking positions just when the chart reverses. I am hoping I know better by the end of this module 🙂

1) To square off you have two options – either you can select the ‘square off’ button from Admin positions or your can simply select the contract (8900 Call in your case), press F2 (becuase you were long on 8900 Call) and press submit. When you do so the RMS software is intelligent enough to understand that there is an existing open long position against your client id and hence it will net you off and close all position. So as simple as that. Also imagine you have 1 lot of 8900 call option..you decide to press F2 to square off this open position…but instead of 1 lot you enter 2 lots then the system will square off your 1 long position and create 1 short position.

2) To write options you will have to select the contract you wish to write and press F2…or simply call your broker and ask him to write, no other way to this 🙂

3) To excersie an option contract that you own you should leave it ‘just like that to expiry’. Exchange do the rest. However when you have written and option and it is profitable I would advice you to square off the position instead of leaving it to the exchange as it attract taxes. More on this aspect later in the module

Yeah, options is a little tricky instrument to trade. They are multi dimensions unlike futures where only the direction matters. I hope you will fully appreciate this aspect as we progress in this module…and also, I hope I can convince you that option writing is not really a scary thing, as long as you are fully aware of the circumstances under which you are shorting.

On the same topic (Saurabh’s)….the “square off” button helps close an open position at market price, while placing a contrary order gives you the option (choice) to sell/buy at a “limit” price, right? Just confirming an assumption that I’ve made till now.

Sir, Highly appreciated the way you are answering our questions patiently (some appears to be small/silly). I want to clear myself from my doubt that, if I would have bought a call option on 15.03.15 and the premium/ stock price rose rapidly in two days .Can I square off and take profits or shall I have to wait till expiry. some of my freind told it can be squared off on the same day if were in profits. Thanks/Ragards

You can book your profits as and when you deem appropriate – this means you can buy an option at 9:15 AM for say Rs.10 and a 9:18 AM the premium goes to Rs.11 and you are happy with Rs.1/- profit you can choose to close your option position. There is no need to wait till expiry.

Yes thats true, you can exercise options only by expiry, however you can square off your position anytime you wish. Its important to realize that ‘squaring off’ a position is different from option exercise.

Exercising the option means that you hold the option till expiry. In this case your P&L will depend on the intrinsic value of the option. However you can also choose not to hold the option to expiry…you can trade just the premium. Like buy an option now and sell few minutes later or hold it for few days.

Hi Karthik,
Thanks for the module again.. Here is my doubt.
You said that the call option can only be settled on the date of expiry. So, if I buy a Call option at a particular premium and the stock rallies before the expiry, Can i close my positions to get the benefit of that rally before the contract expires???

Sorry to butt in on an older thread, i’m trying to learn options and regarding this answer, I’ve a doubt…
What does it mean by ” call option can only be settled on the date of expiry”, if it can be squared off any time ?? doesn’t it sound contradicting ?

Sir,
Applauds to your explanation/chapters on Options, While observing option chains, Is it advisable to keep highest Call Base ( which has High Oi) and Highest Put Base as Resistance and support level for Indices/stocks. Thanks

Hi karthik,
if i wanted to buy call/ put option based on support and resistance for that how to calculate correct premium. and pls can u clarify importance of IV(implied volatility ) and OI.
Thanks/Regards

We will discuss about volatility (including implied volatility) shortly in this module. When you buy options based on support or resistance there is no special way to calculate the premiums…you will have to go with what is being quoted in the market.

sir suppose i buy itc 370 call option at 1 rs when itc is at 350 now if itc falls to 340 and premium becomes .50, can i exit the call by selling it @ .50? and also will it mean that i have lost 1*1000 which i paid as premium

Thank you sir… Before going through you chapter I read a lot of articles, but had many doubts, but your chapters made every thing clear, now i can start trading in options. Thanks again, you are doing a great job…!!

Dear Subhankar
When you buy an option and minutes later if you sell, the open interest created by you because of buying option will be closed on selling option even if it is minutes later. This is what we call squaring off.

hi,
Please correct me if i am wrong. Underlying price is the one at which the stock is currently trading and strike price is the one at which stock can be bought
if the strike price is above the underlying price, and if attained gives you profit
if the strike price is below the underlying price, and the underlying price in future goes up, how a profit is booked

Sir if Iam the writer and have sold a call say of ITC @310 for Rs30/-. Now ITC falls to 305/- in a weeks time. I am in profit at this time.. can I square it now or does a writer have to wait till expiry.

Hello Sir, in your tutorial u mentioned, “Further assume, after he buys the 340 call option, the stock price increases to 360 the very next day. Under such a scenario, the option buyer cannot ask for a settlement (he cannot exercise) against the call option he holds. Settlement will happen only on the day of the expiry, based on the price the asset is trading in the spot market on the expiry day.”

Now your answering questions saying that if one is in profit then can close the option position any time. I am a little confused. Please help

We are talking about two things here, sorry if I’ve confused your here. When you buy a call option @340 and next day it goes to 360, you clearly have made a profit here – you can take this profit and close your trade. However settlement is waiting till expiry and taking your Profit or loss on the expiry day. If you take your P or L on expiry day then you can treat this as settlement…else consider this as regular Profit loss booking. Hope I dint confuse you further 🙂

Yes, I think I am clear now. It means that we can close the trade before the expiry date as per our profits but the settlement of that trade will still happen on the expiry date. So closing a trade and settlement are two different activities in your context. Please correct me if I am wrong.

Thanks for the clarification. One more doubt I have. In the same example, wherein, I bought a call option at 340 and next day it went up to 360 and I have closed the trade watching my profit. Now, if the stock price again goes to 330 after 2 days and before the expiry so what would be the settlement of the trade?? Whether, I would be in profit as 360 closing price or 330 would get considered??? Or I would not get impacted by any price change before expiry at all once I have closed the trade??

continuing the doubt of Mr Saurabh Garg; for example I used a premium amount of 10000 to buy a call option at 340 and sold it at 360 on the next day (well before the expiry date) .
Will I be able to use the 10000 + profit gained in the above transaction to buy a new call option?
When will the money be credited into the trading account on the day on which the option was sold or after the exipry date of the option?

So in this case the money will be in your account the same day (which you can use for some other transaction). In case you do not use this for any transaction the money will be ready for withdrawal the next day.

Hi,
Firstly thanks for giving us an understanding on options in the simplest way possible.

My doubt here is that, I have studied the premium charts and as the markets approach the expiry the premium decreases. Incase I have purchased JP Associates call 1 week prior to expiry at 1/- (1 lot @ spot price 12) and at the day of expiry the price of the premium is 0.15 paise I will still make profit if the rate of JP Associates is 14/- and I square off my trade.
My profit:
((14-12) * lot size) – premium paid

Darshan – Firstly you should not look at the charts of option premium. Its not the right way to approach the option markets.

In case of the example quoted – In case you have bought a call option at Rs.1, when the spot is at 12, then when the spot goes to 14, then all option strikes below 14 will be profitable…all option strikes at 14 and above will not be profitable.

Dear Kartik
first of all accept my heart felt gratitude for doing such a fantastic work .
But I am bit confused by your reply to this particular query of Mr Darshan. Why should it not be profitable when the spot price is at 14 or above?In fact wouldn’t it be as much more profitable as the spot price is more than 14?

Hi Karthik,
In the mentioned scenario of this Call Option, the profit would be exactly the same as Darshan calculated [((14-12) * lot size) – premium]?
It means, once the Spot price is crossed above the Strike Price, it doesn’t matter what the current premium rate is going on…eg. it may be above 1 or below 1. Current premium rate is not our concern anymore. Our profit will be simply the difference between Spot and Strike Price after compensating paid premium (at the time of entering the contract).
Please rectify me if I am wrong.

Upon expiry, the profit will be the difference between the spot price and the premium. However, if this is during the series, the P&L will be based on the difference between the price at which you buy and sell the options i.e the difference between premiums.

Hi Karthik,
In the example quoted above by Mr Swamy- [Eg.. Say NIFTY at 10100 & 10000 Strike premium is 200 and at the expiry day NIFTY closed at 10200 and premium is 0.05…], can you pls clarify if the profit calculation mentioned below is correct or not?

Also, can you pls clarify again that though the premium has gone down from 200 to 0.5 (@expiry), but since we are carrying the option till the expiry, the premium at the expiry doesn’t make any effect on the P&L?

Thanks Karthik for verifying the calculation but I didn’t get why are you saying that the premium won’t go down to 0.05. It was 200 at the time of Option purchase and 0.05 at the time of Option expiry. When the Spot price has moved since purchase, why can’t the premium change?

On the NSE site, when I click on any LTP in the options chain for a single stock and not an index (such as NIFTY), and then view the quote’s historical data price for the past 3 months (this peculiarity is only occurring in the past 3 months options and not in the 1 day, 7 days, 2 weeks or 1 month data) then there is a difference between the closing price and the ‘settle price’ for the initial month (that is 3 months ago) when the contracts, turnover, OI, open, high, low is 0. I have three questions.

1. If the contracts, turnover, OI, open, high, low is 0, then how come there is a closing price?
2. What is the ‘settle price’ and why is it so drastically different from the ‘close price’?
3. Why is it unattractive to trade in options for the far month (that is 3 months forward)?

Assuming I’m wrong…I’m guessing this- Since you are viewing the historical data – settlement price could the be closing price on the expiry date – NSE is giving you this information to contrast the closing with actual settlement.

3) Far month contracts usually have less liquidity, hence people don’t prefer to trade contracts where they cannot easily get in and get out.

Hello karthik,thank you first for such a wonderful explanation.
there is one doubt in my my what does it mean by EXERCISING A CONTRACT, i used to trade in option market and if we dont sell an option before expiry it all become zero? am i right ?if not please explain little more how and what price exchange pay for our option
thank you for your response.

Sudeep – when you buy options you can either hold the option till expiry and let the exchange do the settlement for you (this is called Exercising a contract)..or you can close the position before expiry and book profits/loss. Also not all options goto to zero….this depends on the intrinsic value of the option at the time of expiry. Suggest you continue reading this module for more details and better clarity.

In this above example, say If I wish to execute my option on the expiry date and realize profits, Do I need to maintain the an account balance to buy 8000 shares. I’m referring to

On 26th Trader A exercises his right to buy 8000 shares from Trader B
The price at which the transaction will take place is pre decided at Rs.25 (strike price)
Trader A pays Rs.200,000/- (8000 * 25) to Trader B
Against this payment Trader B releases 8000 shares at Rs.25 to Trader A
Trader A almost immediately sells these shares in the open market at Rs.32 per share and receives Rs.256,000/-
Trader A makes a profit of Rs.56,000/- (256000 – 200000) on this transaction

So needs to maintain Rs.20000/- in his account to exercise the contract or can he execute the contract without maintaining enough balance Rs.20,000/- in this case.

Hi, karthik
I had bought idea, strike price @140 rs with a premium 10 rs. and now the price went upto 151 rs and the premium is 12 rs. So if I squre off my position now, will my profit is from the difference in premium ie(12-10) or (151-(140+10)=1)

As you mentioned that if we square off the position before the expiry date the profit/Loss will be counted only on premium. While strike price will not be considered for P/L. Please correct me if I misunderstood.

Hi karthik, a little query… suppose i buy nifty 8200 CE one day proir expiry @ rs 5 , now its expiry day , and there is not much movement till 3 pm, hence the premium has dropped down significantly to say rs 1 …. suddenly there is activity and the index has started moving… and its on 8215 @ 3.15 pm… but the premium is still below the buying price…. now what sud one do here…..? Hope that the index closes over 8200…n let the contract expire and let the exchange do the rest…. (in this case, i have heard exchange levies certain taxes, what are those and how much), or square off the position at loss…(as the premium has depriciated )

Ravi – if Nity spot is at 8215 at 3:15 PM on the day of the expiry, then 8200 CE will be priced closed to its intrensic value i.e Rs.15…its unlikely for the option to trade below Rs.5 (the price that you have paid for option). Also, its very difficult to predict what is likely to happen in the last 15 mins of expiry.

Karthik I would like to understand what is the difference between profit booking and exercising the option. both have to be different because profit booking can be done anytime but exercising the option can only be done at the time of expiryin European options

Sir, while discussing about land example u said…profit to ajay is (underlying value on option expiry – strike price + premium) but in the previous comments u said profile is the dif between option premium on expiry – option premium on date of contract..please explain it sir? Thanks in adavance

Thanks for this Module Karthik, and answers you have given which helped me understand it much better way..!
1 more doubt i am left with is , when i am buying a call option for Nifty say 8000ce where the underlying price is 7790 and when it comes to 7840 the premium amount also increases and i opt to book my profit with this.
Than why it is always said that?
“The option buyer benefits only if the price of the asset increases higher than the strike price”
and ” The Option Call can only be executed on the Expiry Day” when it is possible to exit even after few minutes of buying.

There are 2 things here – trading the premium and holding the option to expiry. If you intend to trade the premium, you can do so by buying and selling the option at anytime, at any frequency. However if you choose to hold till expiry then the lines ” he option buyer benefits only if the price of the asset increases higher than the strike price and ” The Option Call can only be executed on the Expiry Day” come into play.

It means I can book my profit even though the spot price doesn’t hit the strike price.Only matters is difference in premium if I square off my position before expiry.OTM,ATM and ITM matters only if option has to be exercised.

If person A writes call option and B buys it, who after some time books profit and sells it to C who in the end exercises his right on expiry, then who pays C, Original writer (person A) or the last person who sold the option(person B)?

Dear Sir,
On the expiry of Call option, if the spot price is more than Strike price, the difference is paid to the Option buyer.
or the Spot price should be more than the strike price+ premium paid, for getting the difference on settlement.
Eg. Strike Price Rs. 350 Spot Price Rs.355 Premium Paid Rs.6…. Lot 1000 Will I get Rs.(355-350)*1000= 5000 ?

Technically Spot being greater than the strikes qualifies the option as in the money, hence you as a buyer will get the differential money (settled in cash). However you will also have to recover for the premium you have paid hence Spot price should be more than the strike price+ premium paid for you to truly profit from the trade.

In the example you have quoted you will get 5000, but still end up making a loss of 1000 as you have paid 6000 towards premium.

hi sir
a small doubt. if i bought a call option at 3 Rs of strike price 100Rs. now the underlying is at 110 RS AND option price is 5 Rs.
now if i square off before the expiry date will i get 10 Rs(110-100) OR 2 Rs (5-3).
ANOTHER DOUBT to square off my open call option will i have to sell this option or i have to write call option(opposite side) to close this position.

I heartly congratulate KARTIK RANGAPPA &ZERODHA TEAM HEAD MR KAMAT. for giving flawless knowledge about options . As I am trading in this section i have faced problems.1. when squareoff is pressed it is not taking order & blocked msg is appearing. then stl order is put so many times my order is skipped.with this loss occured. 2. usually after 15th of month nearing expairy even though share price is raising call optional rate is not increasing instead decrasing. with this innocent trader like me , expecting proposional rise but not happening. kindly clarify.

I’m not clear about your first query. But the 2nd one – call prices not increasing even though underlying prices are – for this you need to read up on Delta and other option Greeks. I’d suggest you read according to the chapter number sequence to understand this best!

Interestingly in the jpassociate example, the strike price is lesser than the price of the underlying asset. So invariably if the price of the underlying asset remains at 25.90, would we still make a profit at our strike price of 25 or would we not make any profit since the options strike price also remains the same since it is derived from the stock price

“option buyer cannot ask for a settlement (he cannot exercise) against the call option he holds. Settlement will happen only on the day of the expiry, based on the price the asset is trading in the spot market on the expiry day.” is it so? this means money will be blocked till expiry date.

Karthik sir, options chapters are simply awesome. For all these days I was trading in options just like we trade futures. Never knew there was so much stuff to this.
I have a couple of queries
Scenario 1: On expiry, strike price is greater than spot price
Lets say if I buy a call option at Rs 10 for a particular strike price 25 (For example) and on expiry the spot price of the stock comes down to 20 and premium price for call option is down to 1rupee, Now my strike price is OTM.
What happens if I dont close my position and leave it to exchange for settlement. Clearly am in loss but how much? Does exchange put a penalty on me for the extra loss apart from premium paid?

Scenario 2: Illiquid ITM strike price at expiry
On the expiry day I would select an ITM strike price which is highly illiquid for the spot price movement and buy the call option for 0.05 paisa and left it open. End of the expiry day lets assume that premium price stayed at 0.05 paisa and the difference between the strike price and spot price is 2 (As I have choosen ITM already) then do i get a settlement of (2-0.05) 1.95 per share?

On expiry for a call option, if the spot price is more than the strike price, then the exchange will exercise the option and the buyer will get the difference between these two, but if spot price is less than strike price this option would expire worthless and the buyer will lose the premium paid.

Dear karthick,
Suppose nifty spot is trading at 8600. I bought 8400 put option oct contract by paying a premium of 80. ( It means that, I am as a contract buyer have paid a premium of 80*75 = 6000 to the contract seller)
1. If spot price moves lower the premium of put option increases. let us say 85. So now If want to square the contract (which means i want to sell the already bought contract) I will sell the same at 85. Now here I become a contract seller, So i will receive a premium of 85 (75*85 = 6375). Difference in premium multiplied with lot size is my profit, so my profit is 375. Now the question is whether the trade is over ? or since i sold the contract to someone am i obliged to pay him whenever the prices move against me?
Also Tell me am I correct in every aspect of the above trade?

Hello Sir,
Can u please clear one doubt? As u mentioned, the settlement (or exercising the right) of the contract cant be done before expiry. But the open interest changes on a day to day basis. For example, yesterday OI was 2 lac and today it is 1 lac, so it means that 1 lac contact have been settled or closed. How is it done when when we have few days left for expiry.

Very nice work done by Mr. Karthick Rangappa. I read the first two chapters including the comments section and I can honestly tell you that never have i ever gained so much insight about how options really work..Really proud of you Zerodha!

Hi Sir,
Fantastic job done by you and Team Zerodha, I have read many books on Options but your efforts are worthy to make a layman understand “Options Trading”. I have a query.
“Squaring off” position means, after seeking profit or loss on basis of premium we can stop or terminate trade any time before expiry date. But “Option exercise” will happen only on expiry date. Only on expiry date profit, loss or deducted premium money will execute?

Sir,
I have a question regarding the options trading. If I bought an ITC call option at 350 and sold it at 370 and booked the profits, if a trader exercises his rights, am i subjucted to cash settlement or am I out of the market? Will it still be a risk even after booking profits

I have one question for you Karthik . How can a Trader B pays cash differential on expiry if he is only obligated to sell shares? Can you elaborate on he example as I am not able to understand how can a seller pays profit?

The call option will be profitable only if the spot is above the strike. If the spot is at the strike or below, then the call option wont be profitable. Further, assuming you want to hold the position till expiry, then you will start to make money beyond the breakeven point. Breakeven point is Strike + premium paid, which is 540 + 11 = 551….so spot has to move beyond 551 for you to make money.

“I am in doubt is that would i get additional amount that is Spot price on time of Selling(318) – Strike price on time of Buying(315) = 3
Total= 3*3500= 10500 on the day of expiry, because my trade was “IN THE MONEY” Call option?”

Can you explain in your awsome explaination technique Karthik by giving an example how profit can be made by this which Joyram asked

I got one doubt, in call option, call writer has risk of unlimited loss. In the example, call writer has to cash settle and required to pay 56,000 /- or net loss of 56,000 – 10,800 = 45,200 /- to trader A.

Is there is possibility that call writer might default in this case, how does exchange ensure call writer to lock up sufficient funds in case underlying price rises, does it requires margin call for call writer every time the underlying price rises for call options.

Dear Karthik/Team,
While answering to one of the above query , you stated that since Margin is blocked for any contract , especially the seller/writer of the options, there cant be a default . Is it right to say that “by unlimited loss to seller ” means that maximum loss a seller/writer of an option can make is the margin money that is blocked and that is already known before getting into the contract ? .

sir
suppose i buy one lot of nifty 1300 pe/ce @ 65 / for the current month and my premium paid is assume as rs 4875. and i close the contract with 10 points profit. what will be the amount i receive ,the reward for 10 points only or my premium 4875+ 10 points reward as a new one i have this doubt or should wait for a decent profit above my premium value. please explain me as we express we are in 10 points profit and nothing is spoke of the premium.

I believe time to expiry should not play a huge role in premium price for European options(beyond adjusting for risk-free interest rate). The language you used for the 1 acre land example, of ‘something happening’ within a timeframe, seems more suited to American options unless the frequency of (positive and negative) ‘events’ is so low that the probability of a single event happening in a timeframe is far greater than of two events happening.

Time does play an important role here. Will the premium not increase if the likelihood of an event increases, especially in the backdrop of ample time? Now, imagine the likelihood increasing, but with very less time to expiry? How will the premium react?

If I’m buyer of the of the option contract and it’s price ended in profit after deducting premium. In that case I want to exercise the option contract. So, how shall one do that? Is that automatically the close price on the day of expiry is taken for the cash settlement? Or Is there some procedure to exercise option contract?

Well, it depends on what position you intend to take. You can buy 10300 PE, but to make money, Nifty has to fall further on. Or you can sell 10300 PE, and for you to make money, the market has to go up.

Date on 28/03/2018 i buy 3 LOT option of FORTIS Strike Price Is 140 the premium amount is 0.05 and the Spot Price is around 128

expire date is 26 April 2018.
total premium amount is 3500*3*0.05= 525
end of the day the premium amount till 0.05
and next 4 day Holiday the stock is showing open position in q.zerodha.com but not showing in kite TT
and date of 02 April 2018 stocks are not showing in both TT

my question is what happen with FORTIS stocks the expire date is 26 April 2018
what about my premium amount .

Sir,
I purchased a Call Option of XYZ at strike price of 100 at a premium of 5. (Lot Size 1000)

1. At the time of purchasing , I have to give only 5000.( Plus charges if any.) Am I right?

On the expiry day morning XYZ is trading at Rs 120.

2. Whether I have to sell my Option contract before end of day if if don,t have 100,000 (100 X 1000) in my trading account.?
3. What will happen if I allows the contract to expire with hardly any money in my account.?
4. if XYZ is likely to close in 104-106 range what strategy I should adopt on expiry day..will the contract automatically exercised and will that cause a big loss due to STT.?
Thanks in advance.

1) Yes, it would be 5K plus charges.
2) No, you can just sell it and pocket the difference in the premium
3) Nothing really, but its best you sell the option before expiry to avoid high STT charges
4) Yes, hence its better to exit before expiry.

Sir
On expiry an option is exercised when the spot price on expiry hits strike price, not break even point. Am I right?
If the spot price on expiry is between spot price and break even point or even just cross BE point), then we will not get any profit, but we have to pay a good amount as STT. resulting in a negative balance sheet. Is it so?
How much is the STT percentage?
If I want to settle before expiry, a buyer for my CE should be there. Right? If no buyer how can I square it OFF?
Thanks.

Hello kartik,
My question is again related to the expiry, I have understood that if one wants he can book profits any time before expiry (all thanks to you). But now my doubt is if the underlying price(current market price) goes above strike price in that case only the buyer cannot claim for the settlement.He has to wait till the expiry.Right?

Hello Karthik,
Thanks for the good article. From your article, I have taken the below, it says one cannot go for settlement or book profits before expiry. But in actual one can buy an option contract today and can sell any time before expiry. What do you mean by below? Confusing to me. Kindly clarify.

“Hence, assume with 15 days to expiry one buys ITC 340 Call option when ITC is trading at 330 in the spot market. Further assume, after he buys the 340 call option, the stock price increases to 360 the very next day. Under such a scenario, the option buyer cannot ask for a settlement (he cannot exercise) against the call option he holds. Settlement will happen only on the day of the expiry, based on the price the asset is trading in the spot market on the expiry day.”

Settlement here means the value of the option upon expiry. You need to note that the settlement of the option as per the expiry is one thing and selling the option to gain from the difference in premium is another.

In simple words, you buy an option at a premium today, you can sell it anytime, including the very next second. The profit or loss you make is the difference between premium. On the other hand, you can buy the option today and hold it to expiry. If you do so, the profit or loss is dependent on the value of the option upon expiry aka the settlement price. Hope this makes sense 🙂

Can you tell the new margin (post 14th sept.) required for selling Nifty puts? I tried calculating using the zerodha margin calculator but it appears to be giving the margins applicable before 14th sep (or maybe I’m wrong).

Thanks for the great content.
Well explained for newbies.
Could you please clarify the following:
In the Buy Call Options examples,
the interest cost doesn’t appear
to have been factored. Like in the
JP Assoc example the profit is said
to be Rs. 45,200.00 (56,000-10,800).
What about the interest cost on the
Premium of Rs. 10,800 from 15th to
26th March?
Thanks

2. If I have option which is not in ITM. What happen a expiry. Can I leave it for auto square off by exchange?

3. If I have option in ITM and not looking for settlement to avoid STT and unable to square off due to illiquid. Either I need to intimate zerodha or exchange for not processing settlement and what is the process for same

2) Yes, the option will expire worthless and hence you will get to retain the entire premium

3) If you are unable to square off and ITM option due to illiquidity, then I’m afraid your position will be settled at the settlement price, as long as the intrinsic price of the option is higher than the STT payable. If it is lesser than that, then the option won’t be exercised.

Your way of explaining the options was simply super.
Probably this was the first book which I went through from the first to last page with ease.

Kudos to you and your team.

I have been trading Nifty Options for few years with no knowledge, at times I made good money and at times I lost them badly. Reading through the book has shown me the reasons for it.

I have always traded in Nifty Option CE buy only for small profits on day to day ( when ever I see a chance) of 3k to 15k, but never trading in CE sell.

Pls clarify me on CE sell :
1.If opt to sell a CE of Nifty say 10300 at LTP of 55.25 at 14:00 hrs – here I am not paying anything , but margin amount will be blocked from my account
2. If the short/ sell at market when LTP at 53.25 at say 14:45 hrs- I will receive
(55.25-53.25)= 3* 75 = 225 , which will credited to my amount after deduction of taxes etc. and will be no other liability and margin amount is released from my account.
Hope my concept is clear and same is applicable to PE sell also.
pls clarify

1) Yes, only the margin amount is blocked
2) If you short again @ 53.25, you will be essentially 2 lots short. If you want to square off, then it will be 2 lots short. By the way, there is no deduction of taxes here.

Mr. Karthik,
I am getting confused regarding squaring of Long Call. My understanding is like this:
1. Suppose I buy one lot of xyz Call option at Strike Price 200 Premium 10. Before expiry if the premium for XYZ for the same strike price is 12, irrespective spot price, if I square off I will get profit of 12-10 =2x lot size.
2. If I allow it to expire. On expiry the Spot price is 212 if my Call is ITM, I Get profit of (212-200)x lot size = 12x lot size – premium I paid, irrespective expiry day premiums of the strike price(200) I purchased and premium Spot(212).
3. My understanding is if you short before expiry the P&L is difference in premiums of Strike Price. On expiry the P& L is the difference in the strike price and spot price minus premium paid.
Please clarify.

Hi,
I need to understand following things:
on date of expiry, In morning IF I buy NIFTY call at SPOT Price: 11000 at premium of RS. 0.05 consider 1 lot and Nifty rose up to 11100 and I am failed to exercise due to unknown reason.. How much Loss I have to bear due to STT and all other charges if its exercise by exchange?
2) How can I protect my self from STT Trap? If I am unable to exercise my call due to unknow reason or there is no buyer.

1) In this case, you will make nearly 100, and lose close to 20 points on STT, so you will make a profit of nearly 75 -80 points.
2) The easiest way is to square off the position just before the expiry.

Thanks for reply.
in 2 Case: You said that square off position just before the expiry, its sounds good but if there is no buyer, am I eligible to square off? if yes then how much profit or loss I can get if Spot price > Strike price?

I have read lots of articles on google where it says you can ask for ” don’t exercise” at the end of expiry. is it true? how can I place request in Zerodha Platform? and how much I loose if this is possible?

In that case, the exchange will do the settlement for you and paying STT upon ITM option is unavoidable. If the option is ‘Close to the money’, then the don’t exercise option is applicable and therefore STT is avoided. The broker takes care of this automatically. But I guess your example was deep ITM, wherein this is not applicable.